Successes and failures in crisis countries

Below is a short statement made in front of the European Parliament in a hearing about “Successes and failures in adjustment program countries”. I was specifically asked to make a few references to Greece, Portugal and Italy.

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STATEMENT

The objectives of adjustment countries are two-fold :

  • In the short run, they need to reduce the financing needs of public administrations in order to restore fiscal sustainability
  • In the long run, they need to raise the level of potential output through structural reforms.

 

The financial crisis has induced policy measures that address both issues. Yet, at present, these economies show little sign of improvement. Unemployment has reached critical levels in Portugal, Greece and Spain. Growth remains anemic and the outlook for public debt is unfavorable despite the painful efforts that have been consented.

The structural adjustment strategy operates under considerable political constraints:

  • In the short run, to offset the contractionary  effects of fiscal adjustment, aggregate demand should be reallocated toward exports, which implies a depreciation of the real exchange rate. Because of the Euro, this is not doable through a currency depreciation. The only alternative is more downward flexibility of nominal wages, which in some countries (Portugal) simply does not seem to be happening, while in others  (Greece) is a protracted painful process replete with political risks.
  • In the long run, to increase incentives to work one needs to reconsider the generosity of the welfare state.  But this runs counter to the political platforms that most political parties had been selling to the electorate for decades. To increase competition one needs to remove barriers to entry in goods markets; but such barriers benefits some well organized interest groups that are likely to oppose deregulation.

These constraints reduce the margin of manoeuver of policy makers and make it all the more important to come up with the best possible structural adjustment package. To date, I believe the measures that have been implemented fall short of that objective, in particular because the consistency between the two objectives mentioned above has been ignored. For structural adjustment to be successful,

  • We need to avoid policy measures that consolidate the accounts in the short-run but have adverse effects on competitiveness and productivity in the long run, and
  • We need to avoid reforms that boost competitiveness and productivity in the long-run but have an immediate negative impact on economic activity and/or fiscal revenues.

 

The pitfall of ignoring those caveats is that the reform package may be unsuccessful overall, as different items in the package will have offsetting effects on both the short-term and the long-term performance of the economy.

Let me now discuss some aspects of structural reforms in program countries under the light of those principles. I will pick some items in the comprehensive reform packages of Portugal, Greece and Italy and discuss the extent to which there is some coherence between their long-run and their short-run effects.

  • Regarding the short-run fiscal adjustment, priority should be given to expenditure-reduction measures as opposed to revenue-augmenting ones. The latter must be associated with a greater tax burden which as such has negative long-run distortionary effects on the economy.  There is a unanimous consensus over the benefits  of greater tax compliance, which is part of the reform package in all program countries. Indeed, in principle, a greater efficiency in tax collection should allow to collect the same amount with lower tax rates, thus reducing distortions. Yet it may also pave the way for future tax increases by opportunistic governments – by simply making such increases less costly, and expectations of such developments may be harmful for investment and growth.
  • In Portugal, severance payments for workers with permanent contracts have been considerably reduced, bringing them in line with the European average. While this reform was long overdue, and will certainly raise productivity and reduce unemployment duration in the long run, I believe it should have been postponed. Its immediate impact is to trigger a wave of job destructions in the middle of the recession, which jeopardizes the country’s short-term macroeconomic objectives. Furthermore, it will have little impact on job creation because most new hires are under temporary contracts whose terms are not affected by that reform.
  • Symmetrically, the attempt to tax temporary contracts in Italy (and France) may be viewed as a useful step toward a unified labor contract that would do away with the inefficiencies of the dual labor market system. But in the short-run it may critically reduce job creation and postpone recovery.
  • On the other hand, the reform of collective bargaining in Portugal, which among other things limits the automatic extension of wage agreements to an entire sector, especially whenever those agreements are signed by unions representing a minority of workers, yields positive benefits both from a long-run and a short-run perspective (A somewhat similar reform in Italy tries to allow firms to bypass collective bargaining by resorting to individual bargaining). In the long-run, it will reduce the equilibrium rate of unemployment, in particular since intersectorial labor reallocation will proceed through wage differentials instead of unemployment spells . In the short-run, it makes it easier to obtain the necessary level of wage moderation in order to restore external balance and bring down unemployment back to acceptable levels. I should hasten to add that, in the case of Portugal,  unfortunately this is likely to be insufficient, as the required adjustment in wages is probably around a 10-20 % reduction in nominal wages, which could only be obtained through a devaluation that the Euro precludes.
  • Presumably in order to alleviate the immediate consequences of the crisis, in particular the very high unemployment rate, Greece is extending its social safety net.  This includes relief jobs, vocational training, basic guaranteed income as well as an extension of health benefit coverage.  These programs are being financed by European structural funds and by the World Bank.  While these measures are understandable given the political context, they are unwise; relief jobs are inefficient and  schemes like basic minimum income are very difficult to undo and will create poverty traps. Greece probably cannot afford a level of social protection on par with Scandinavian countries. I believe this illustrates how a poor macroeconomic situation may create political support for policies that have long-run adverse consequences for the economy.
  • Deregulation of protected professions – that is part of the reform package in Greece and Italy – should have positive effects both in the long run and in the short run. In the long run, the allocation of labor is more efficient and the cost of services to consumers falls. In the short run, the unemployed may enter those professions which alleviates the unemployment problem.

The severe fiscal crisis has brought forward a “day of reckoning” which has led countries to implement a catch-all adjustment program including many structural reforms that had long been discussed under different macroeconomic contexts. I think the above examples illustrate that one should have been more discriminating in selecting those reforms given the specificities of the Euro sovereign debt crisis.

 

 

The political economy of the Breton upheaval. II: A symptom of collective mad cow disease.

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I will continue my discussion of the Breton upheaval by discussing its economic, or rather mad-cow-nomic, roots.

Over the last two decades French public opinion has become increasingly vocal against globalization. All political parties have to some extent a protectionist stance, if only a nominal one. The “extreme” parties are outright protectionists. The ruling parties’ platforms include a cosmetic industrial policy agenda to make-up for the fact that they will abide by international treaties and therefore are in no position to close frontiers.

The arguments of the opponents to globalization are simple. How can a French firm with high labor costs compete with a Romanian firm with low labor costs? The French firm will have to close and its employees will be out of jobs. If globalization puts people out of jobs, why does the European Union write reports saying it is good for the economy? And why is it imposed upon the French people, increasingly against their consent?

At the same time, there is much less support for protectionism in other countries with similar levels of developments, such as the U.S., the U.K., Sweden or Germany. These countries seem to adapt better to globalization, in fact they are more globalized than France; the Bolkestein directive has been implemented to a greater extent in the UK and then Germany than in France, and yet their population is more sympathetic to trade. Indeed, in Germany the unemployment rate has constantly fallen throughout “the worst crisis since the great depression” and is now at a minute 5 %. (According to a French magazine, this is “the example not to be followed”.)

We could believe that the French are brainwashed, and that may be true to some extent, but facts seem to confirm their views. Every day a prominent firm announces that it will close or downsize, and the Breton food and agricultural industry is one of the most exposed ones. Could it be that globalization is good for Germany and bad for France? And what differences between these economies could account for that?

To answer those questions, we need to understand why wages are low in Romania in the first place. And we need to understand why we may gain from trading with them despite that some firms can’t compete with their low wage producers.

Suppose we only trade with countries with a similar level of development. Then, clearly, no firm would have to shut down because its foreign competitors have lower costs. Consumers would gain not because they would import cheaper products, but only because they would consume a broader range of products. Yet even in such a situation, some firms would have to close, because they are less productive than their German competitors; and some German firms would have to close, because they are less productive than their French competitors. This should be no problem; because France and Germany have a comparable distribution of skills, trading between them does not impact the distribution of wages. So if lose my job because some German firms are more efficient than my employer, I can expect to find another job at a similar wage elsewhere. In fact, reallocating resources to the most productive competitors increases the productive capacity of both economies and makes everybody better-off.

Yet if you describe this scenario to a French, he will object that once he has lost his job, he won’t find another one. The scenario only works if the economy is sufficiently flexible to smoothly reallocate labor between firms. And that is not the case of the French economy.

Suppose now that instead of trading with Germany, we trade with Romania. These people earn much lower wages. Yet that must be for a reason. If they were as productive as the French in all sectors, they would have the same real wage and real living standards. Any differences in nominal wages would then just be a matter of exchange rate misalignment. The Romanians must therefore be less productive than the French. But if they were uniformly less productive than the French, they would not be able to undermine the competitiveness of French firms. A French firm which pays 100 to workers who produce 100, can sell its good at the same price as a Romanian firm which pays 50 to workers who produce 50.

The problem comes from the fact that the Romanians are not uniformly less productive. They may be far less productive at making airplanes, but equally productive at producing poultry. They only earn 50 because of their low productivity at making airplanes, but their poultry firms pay 50 to their workers who produce 100, while the similar French competitor has to pay 100 and needs to sell its production at twice the price. When forced to compete with the Romanian firm, the French firm has to close unless its own wages fall down to 50. If that happens, its workers will become much more attractive to hire for the aircraft industry and will relocate there. The aircraft industry will grow and indeed it would attract all the former workers of the poultry industry if workers were identical. Given that the aircraft industry does not suffer from competition from Romania, eventually no worker has suffered a wage loss and people are better-off because they can consume cheaper Romanian chicken that is financed by exporting aircrafts. But perhaps workers in the poultry industry are not so productive in the aircraft industry because they are  “unskilled”, and through trade they have to indirectly compete with Romanian unskilled workers who are relatively more abundant. Then the unskilled workers end up with lower wages, but their wage losses are smaller, the better their ability to relocate.

Then, you might ask, why would the unskilled accept trade with Romania if their wages fall? The answer is: they wouldn’t! But in theory we may design the shift to globalization in such a way that they are compensated for the wage losses. We could levy a tax on the consumers, who benefit from cheaper imports, and finance a transfer to the unskilled, who also benefit from cheaper imports but not enough for this to offset the effect of their wage losses, in such a way that everybody is better-off. This is because free trade generates global net gains at the aggregate level.

Of course, one does not have to do it. It is written nowhere that the losers from public policies have to be compensated. In fact most public policies are zero-sum (or even negative-sum) redistributive ones such that compensating the losers is impossible because the policy does not generate any gains. Its legitimacy comes from “consent” of at least a majority of voters. But, as we have seen, that kind of “consent” has been denied to the French in the case of the Eastern enlargement of the European union.

But the central issue is that the French economy does not work as described. In fact it has been designed in such a way that participation in a free-trade zone with low wage countries has catastrophic consequences.

On the one hand, market rigidities make the adjustment to foreign competition more painful, and magnify the losses for the social groups exposed to it. Workers who can no longer compete with their Romanian counterparts have to lose their jobs, because minimum wages and collective agreements make it impossible for them to have a wage cut. Regulation makes it harder for them to relocate to another industry or location. For example, they would have to buy a costly license should they want to become a taxi driver, or to spend years getting a degree should they want to open a hair salon. They would lose their order of priority in access to social housing should they want to accept a job elsewhere.

On the other hand, participating in a global market increase the economic distortions associated with taxes and regulations. For example, in a closed economy, an increase in social minima would make unskilled labor more expensive to hire, and firms that employ lots of unskilled workers could adjust by raising prices. This would generate some employment losses and welfare losses for consumers. But these losses would be smaller than in an open economy, where those firms could no longer raise prices, since their customers would then shift to foreign competitors. Instead they would have to close and their workers would become unemployed.

Many other handicaps compound those issues, such as the working time regulation, the gradual piling up of safety and environmental regulations, the ever crawling up payroll taxes, and the Euro.

With a rigid economy, losers lose more, and gainers gain less, from globalization. It is no longer obvious that there are aggregate gains from trade. To compensate the losers one needs a greater tax hike than in a flexible economy, and it may be impossible for everybody to gain.

The  inherent contradiction in French economic policy is to insist on implementing ideologies that hamper markets, while at the same time participating in globalization, which makes flexible markets more necessary. French politicians live under the delusion that they can survive that contradiction by making it up with subsidies. Last week only the government spent 5 billion Euros of taxpayer money to appease interest groups, including the angry Bretons. They hope that they can find some more malleable people willing to remain silent while they have to pay more taxes to finance the subsidies that the more vocal, connected, or violent groups managed to get for themselves.

Suggested reading: Saint-Paul, Gilles (2007) Making Sense of Bolkestein-Bashing: Trade Liberalization under Segmented Labor Markets.Journal of International Economics, 73 (1). pp. 152-174.

Suggested movie: Que la fête commence, by Bertrand Tavernier, with French actor jean-Pierre Marielle at his best in the role of Breton dissident Pontcallec.

The political economy of the Breton upheaval: I. No taxation without representation

 

pontcallec

The central government in Paris is facing an old-style peasant wave of unrest in the westernmost part of the country. Small entrepreneurs, workers, farmers and many other people have congregated to oppose, with some degree of violence, a new tax on commercial road transport (with the trendy P.C. label “écotaxe”) that is currently being implemented and had been decided by the preceding government in the name of “sustainable development”.

France is famous for its street protests of a more or less violent form, and this tradition is continuing because it works. Historically, governments have backed down on many policy measures because opponents managed to make life impossible for them.

On paper, there is nothing legitimate in trying to cancel the choices of a democratically elected government through violence. And Brittany has given a large majority to the current government in 2012, thus endorsing more expenditures, more redistribution, more regulation, and more taxes. Who did they expect would foot the bill?

If however we turn to the substance, the root cause of the upheaval is two-fold. First, if you administer people a hefty dose of mad-cow-nomics, they predictably become crazy. Second, people are increasingly taken hostages by a ruling elite which seems totally out of control.

The mad-cow-nomics of the Breton upheaval are the following. On the one hand, people are asked to be competitive in the European single market. On the other hand, the institutional context in France and most recent policy measures are just prohibiting them from becoming competitive. The écotaxe is just the turburlence which triggers the final blast of the pressure cooker.

On the one hand, the Breton agricultural producers are supposed to compete with large German plants that reportedly hire workers from Romania and Bulgaria at Romanian and Bulgarian wages, thanks to the Bolkestein directive.

On the other hand, they have to pay their own workers French minimum wages, topped up by high social security contributions, abide by a myriad of costly regulations, and are a privileged target for more regulations and taxes in the name of “sustainable development”. In particular, the Bolkestein directive is not implemented in France to the same extent as Germany, so they cannot replicate the German strategy of importing cheap labor from the East. The French road transport tax is more severe for medium-size trucks than the German one, adding to the problem. And Schröder-style reforms are unheard of around here, meaning that the minimum wage has kept crawling up — some 17 % of the employed are paid the minimum wage, an astronomical proportion by international standards.

Historically these handicaps were offset by subsidies. But as the subsidies are phased out, the Breton producers can no longer break even.

In the context of the upheaval, we notice repeated attacks on speeding radars, which may sound anecdotal. In fact people have been furious against those radars from the start; they epitomize the contempt of the ruling class for them. They are strategically located at places where the speed limit is abnormally low given the configuration of the road. They impose a mental torture on drivers, especially of course on those who have to drive constantly in their profession. Nobody believes they have anything to do with road safety. They are a consequence of a global ideology where politicians incarnate some moral principle — sustainable development, gender equality, public health, solidarity, European unification — and consequently people are accountable to politicians instead of the other way round. In turn this ideology serves as an excuse for the elites to increase their power and extract more resources from the population.

In 2007 people voted for Sarkozy because he sounded more receptive to the actual problems of the people. Immediately after he was elected he scattered the territory with those radars, while at the same time hiring politicians from the defeated socialist party in his government. At that point people understood that they had been grudged.

How can one explain to the Bretons that there is any good for them in enlarging the European Union to the East and in implementing the Bolkestein directive? This is made more difficult by the fact that there is no democratic legitimacy to such enlargement. Nobody in France was asked their opinion about whether Bulgaria, Slovenia or Latvia should be part of the Union: There was no referendum. To be sure, the parliament agreed. But the two main parties are unanimous over everything European. That is, the scope and scale of the European Union are simply taken out of the debate — in the former Eastern Germany there were 11 political parties; but things like freedom of speech, a market economy or reunification were, similarly, taken out of the debate.

At the same time as we have no say on the frontiers of the Union, we are told that we need more political unification, which of course makes it even more important that enlargement should be subject to referendum. It’s as if the U.S. congress suddenly decided that Mexico, Venezuela and Colombia would now become U.S. states. What would the American people say? In fact such a scenario is not even conceivable.

Once upon a time, transfers of political sovereignty to Brussels were subject to referendums. In 1992 the French said yes to the Maastricht treaty, after a campaign which skillfully lumped together membership of the Euro area with the very existence of the EU (then EEC). In 2005 the French said no and since then there has not been a referendum. We are allowed to have referendums only if we say yes.

The Bretons are angry because they (and other French people alike) have not given consent to any of the things that are imposed on them. They have not consented to the Eastern enlargement, they have not consented to the Bolkestein directive, they have not consented to the écotaxe, and they have not consented to the speeding radars (another bipartisan consensus).

From 1300 to 1660 the kings of France, when levying new taxes, needed the consent of a popular assembly called the Etats Généraux. While political representation was not equal across people, the members of this assembly were not professional politicians but genuine representatives of their constituency. It was not rare for the assembly to say no to a tax proposed by the king. The scope for manufactured consensus to make a mockery of popular representation was lower, precisely because the representative of shopkeepers was not a career politician but a shopkeeper, who would personally experience the pain of any new tax on shopkeepers. Circa 1660 the Capetian dynasty stopped resorting to the Etats Generaux and became a dicature called absolutism. It lasted another 130 years.